As the American public warms up to the stock market and its record numbers, those investing only in the public market may be inadvertently exposing themselves to the same financial destruction experienced in previous recessions.
As the stock market continues to hit record highs, fears of a bubble in the stock and bond markets are growing among experts, and for good reason. Historical findings demonstrate that if investors invest only while the stock market has a price-earnings ratio (PE) over 20, then their returns will likely be under 3% annually over a twenty-year period. Today’s PE is just over 30, the third-highest in history outside of Black Tuesday in 1929 and the dot-com bubble in 2000.
How Traditional Portfolio Theory got Diversification Wrong
Modern Portfolio Theory, first introduced by economist Harry Markowitz in the 1950s, has over time turned into what most people today think of as traditional portfolio allocation. This widely used allocation model recommends a portfolio diversified mainly across public stocks and bonds. Critically, it fails to fulfill diversification needs of modern investors. As public asset classes have become more correlated, the modern portfolio theory investment model has offered investors less diversification, more volatility and, ultimately, portfolios with risk that outmatch potential returns. The recent Fundrise white paper, The Shortcomings of Modern Portfolio Theory In Today’s Macroeconomic Environment, found that a portfolio invested according to the Modern Portfolio Theory is:
- Excessively correlated: A typical portfolio modeled after the outdated Modern Portfolio Theory is concentrated only in corporate stocks and bonds, both of which are highly correlated to the broader market. With historically low yields, bonds no longer offer the diversification that they did when the Modern Portfolio Theory was created. Moreover, a JPMorgan study finds that cross-industry equity correlations are at record highs, and projects this to only worsen. This means that if a market dip occurs, a portfolio of stocks and bonds will be vulnerable to major price swings.
- Dangerously Volatile: While volatility is at a historic low, average volatility levels since the financial crisis have remained elevated. For instance, the CBOE Volatility Index has increased by nearly 30% since Lehman Brothers filed for Chapter 11 bankruptcy protection in September of 2008. A Blackstone study also finds that the S&P 500 has experienced swings of 3% or greater 1.5 times more since 2000 than over the preceding half-century. In light of these volatile swings, investors without adequate diversification across multiple asset classes will be needlessly susceptible to market fluctuations.
- Underperforming Other Investment Models: Bond yields are at historic lows, and economists project prolonged slow growth in the coming years, which could negatively affect stock returns as well. The McKinsey Global Institute projects that equity returns will fall by 140-240 basis points over the coming years. Those investing according to the Modern Portfolio Theory will likely experience disappointing returns without further diversification into other asset classes.
Modernizing Modern Portfolio Theory: MPT 2.0
At the heart of Modern Portfolio Theory is the understanding that in order for a portfolio to be truly diversified, its investments must be allocated across several uncorrelated assets. With modern modifications, MPT 2.0 can achieve the diversification that the original theory aimed to achieve, creating a portfolio better suited to endure potential financial crises.
Principally, Modern Portfolio Theory 2.0 requires a greater mixture of asset classes with lower correlation to the broader market than that offered by stocks and bonds. This change will provide potentially higher returns and reduce portfolio correlation, volatility, and ultimately risk.
To achieve this, our research shows that investors should expand their portfolios beyond the stock market to include both public market and private market investments. Private market investments provide vital diversification into assets uncorrelated with stocks and bonds, which can improve risk-adjusted returns through higher yield potential, lower beta, and greater protection from market volatility. In fact, a Wells Fargo study finds that historically certain private market assets have captured more than 80% of developed market equity return benefits in up markets but less than 50% of pullback in down markets.
For a complete analysis of the shortfalls and modernization opportunities of Modern Portfolio Theory in the market today, you can read the white paper, The Shortcomings of Modern Portfolio Theory In Today’s Macroeconomic Environment.